OPINION LEGAL

Sunday, March 5, 2017

BORDER ADJUSTMENT TAX

The
Trump administration seems more than willing to break with liberal orthodoxy on
trade. Could this lead them to introduce a "destination tax",
essentially penalising imports? If the USA moves ahead with this idea, MarkHallerberg argues that the EU should seriously consider doing the same. Not
only would it balance out some of the trade effects of the US move, it might also have positive political
implications for Europe.

“Two
developments from Washington
pose a challenge to the liberal economic order, of which free trade is the most
emblematic tenet.

One
is the Trump administration’s threat to move from multilateral trade
agreements, such as NAFTA, to bilateral trade agreements. The
administration has been clear that it wants to negotiate separately with Canada and with Mexico. Reinforcing this general
pattern is an implicit attack on the World Trade Organization (WTO) itself. The
introduction of import tariffs of 35% on any firm that outsourced jobs abroad
would be a clear violation of WTO agreements, as would a unilateral tariff on
imports from Mexico or China.

A
second development is the increasing popularity of the so-called
“destination tax” in Republican circles. This is a cash flow tax. This
tax would favour American-produced products over foreign ones. The reason is as
follows. Any input a company imports would have to pay a tax rate of, say,
20%. Any output a company exported would not pay this tax.

If
one lives in a country with a value-added tax (VAT), this would sound somewhat
familiar — one does not pay VAT on what one exports because a company
generally receives a VAT refund on what it exports. A difference between the
two taxes is that both imports and domestically-produced items pay the
same VAT. This new destination tax would charge a 20% rate on the imports as
total value added. Domestic firms, however, would start with total value but be
able to deduct the wage bill.

In
terms of effects on trade, this means that imports to the US would face a disadvantage while US exporters,
who would not pay tax on what they export, would benefit. How much they benefit
would depend on other factors. There are probable currency implications, for
example, with some assuming that the dollar would appreciate and perhaps even
cancel out the benefits to exporters from the advantages of the new tax. Moreover,
such a tax could contravene WTO rules.

However,
a recent paper by Gary Clyde Hufbauer and Zhiyao
Lu of the Peterson institute suggests that there may be ways to make the tax
WTO-compatible. This would include changing the tax rate to 15% but introducing
a credit for social security and Medicare taxes, which amount to 15%. As
the PIIE piece correctly notes, this assumes that the Trump administration
would consider the WTO as a true constraint, which is unlikely: then-candidate
Trump already threatened to withdraw the US from the international body in
July 2016.

So,
is it politically realistic that the US federal government will adopt
this tax? There is not yet a clear decision. But House Republicans have been
pushing it for some months. If they decide to go forward, the Republicans do
control both houses of Congress and the Presidency. Moreover, Trump has so far
been consistent in moving ahead with proposed policies that he promised in the
campaign. While Trump did not run on the tax itself, he did pledge to increase
trade barriers, and his Press Secretary, Sean Spicer, seemed to support it as a way to pay for the wall
with Mexico last week.()

This
indeed points to a bigger issue facing Republicans. Keeping their promises of
big tax cuts, no cuts in entitlement (or social transfer) spending, and a big
increase in the size of the US
military will bust the budget. The Congressional Budget Office already projected in a January 2017 update an increase in the US national
debt of about $1 trillion a year over the next ten years if there are no
changes in policy. This tax could potentially generate a lot of revenue,
enough even to fill the income gaps. Moreover, if it replaced the corporate
income tax as it exists today but at a lower tax rate, Republicans would try to
pass it off as a tax cut.

So let’s say the US
adopts a border adjustment tax. What should be the European response?

One option would be to do nothing. One could hope that a big appreciation of the
US dollar would cancel out the trade effects of the double whammy of an implied
subsidy for US exporters and a new tax for European firms who are US importers. This
seems very risky. Many factors affect the exchange rate and the literature is
far from clear whether the exchange rate would actually behave as some theory
papers suggest it would.

A response worth considering may be to introduce the border
adjustment tax in the EU. It could be set at the same rate as the USA tax. This would not completely
level the playing field. And it would affect trade patterns, as inputs into
production from abroad would be treated differently from domestic labour. But
it would diminish the discrepancy in how importers and exporters would be
treated in bilateral trade, as the labour cost would be exempt from the
tax on the export.

This
would directly cancel out the effects on European exporters to the US. It could
still hurt trade with others, but one could negotiate who is “domestic” for the
purposes of the tax. One could add a clause in the negotiations with Canada on CETA,
for example, that made Canadian goods and services “domestic” for the purposes
of the tax.

One potential barrier to this action could be the WTO. The European Union probably cares
more than the Trump administration about preserving this international body. If
the deduction for pension payments in the US
would be accepted at the WTO, one would need to think about some sort of fix to
do the same thing in Europe, where pension
contributions also vary. This could make it too difficult politically to
introduce.

However,
it is also possible that Trump will leave the WTO if he decides he wants the
tax and there is no way around the body, or that he finds another “quick fix”
which other countries could emulate. Trump’s tax move is foreseeable only if
the WTO is not a real constraint on Trump.

There
is another benefit to the border adjustment tax wherever it is introduced,
namely on the revenue side. It is far too easy for corporations to avoid the
current corporate income tax. They can shift profits easily abroad and
undermine domestic tax bases with all sorts of exemptions. A reason for this is
that the current corporate tax system is based on the residence of the firm. There
are incentives for firms to relocate their headquarters abroad and to shift
profits. A tax simply based on domestic value-added would end such tax
avoidance schemes.

As
a January 2017 US Treasury report notes, “‘A destination-based tax, in which
the tax is applied based on the location of consumption or purchases,
eliminates the incentives to shift profits or income-producing activities to
avoid the tax.’’ Even with a lower marginal rate this tax should
boost the revenues that governments collect not only in the US but potentially in Europe.
More broadly, it could even help economies if it increased the efficiency of
the distribution of capital overall by ending the many loopholes businesses now
use because of the design of current corporate taxes.

In
the longer term, the hope would be that the world would move towards this type
of cash flow tax. In effect, all countries would become “domestic.” Such a
system would then eliminate the clear discrimination against imports if
everyone used the same tax.

In
the short- to medium-term, such harmonisation across the world won’t happen. In
the meantime, there may be political benefits to the EU itself from adopting
this tax – even beyond those mentioned above: namely a more level
playing field with the Americans and increased revenues. Under such a tax
regime, there would be significant added value to being a member of the Single
Market.

Brexit
negotiations should obviously not be a reason to adopt a new tax, and it is
doubtful it would be introduced in the European Union during Brexit
negotiations in any case. But we should note the implication. If the
UK wanted to leave without a
deal, it would be treated under the tax like any other country outside the
Single Market, and any imports from the UK would be charged at whatever
rate is agreed (say 20%). A move to this tax now, in fact, would
strengthen the hand of the EU’s Brexit negotiators.

It
is up for debate whether it makes sense for the EU to directly respond to a
unilateral move by President Trump introducing a border adjustment tax. In any
case, its introduction on the European side would be a non-trivial matter. The
tax would basically have to replace the existing corporate taxes, which vary
across member states. To avoid worries about European bureaucrats running it,
national tax administrations would be responsible (much like with VAT).

But preparing this option, also as a credible threat of retaliation,
would enhance the strength of the European Union and show that it means
business on trade. This political effect should not be underestimated. It would indeed be
an irony if Trump’s attempts to divide and conquer led to a more united Europe. One way to do this would be to use the very tax
tool Trump might be about to introduce in the United States."